Will inflation threat jostle rates?

For the past several months, top Federal Reserve officials could have napped through their monthly meetings to decide interest-rate policy - the economy was growing without any signs of inflation.

Now, there's some excitement.

When the Fed meets tomorrow to discuss interest rates the conversation is likely to be spirited, with some members arguing it's time to crank it up a notch. Their evidence: Last week, the April Consumer Price Index (CPI) ticked up significantly, rising 0.7 percent. There are also some signs that the manufacturing end of the economy - moribund in recent months - is also reviving.

Investors didn't like the prospect of a robust economy with some inflation strains beginning to show. On Friday, after the news came out, the Dow Jones Industrial Average dropped 193 points after a record high the day before. The bond market, a good gauge of interest-rate psychology, saw yields rise sharply to just under 6 percent on the widely watched 30-year bond.

"The debate is on: Is this a first sign of inflation getting a toehold or is this a single shot deal?" asks Kevin Flanagan, an economist at Morgan Stanley Dean Witter here.

Only two weeks ago, Fed Chairman Alan Greenspan warned that inflationary pressures could return, "possibly faster than some currently perceive" if productivity slows down or employers keep on their rapid hiring binge.

Mr. Greenspan is particularly concerned that only 10 million people, or 5.75 percent of the work force, are officially counted as unemployed or willing to work but not actively seeking a job.

He worries that the tight labor market will result in wages outpacing productivity gains. For this reason, economists will be watching the May unemployment report when it is issued in the beginning of June.

The most recent inflation report does not indicate that Greenspan needs to worry right now. Behind the CPI rise were higher prices for apparel, tobacco, used cars, food, and gas. "I don't see any broad-based price pressure," says Cynthia Latta, an economist at the McGraw-Hill in Lexington, Mass.

Economist Bruce Steinberg of Merrill Lynch & Co. says the main culprit is higher energy prices because of production cutbacks. Yet, over the past week, oil prices have started to slide lower. "During the balance of the year, further upward pressure on energy prices is likely to be quite limited," predicts Mr. Steinberg.

Price of gypsum board

But there are some signs that inflation and shortages are causing problems. In the critical housing market, insulation prices were up 10 percent in March from a year earlier. Gypsum wallboard is in short supply and is expected to rise about 9 percent this year. There are also shortages of cement and bricks. Add in labor shortages and it's adding over 20 extra days to the time it takes to finish a house.

"The labor market is strung tight as a drum," says David Seiders, chief economist for the National Association of Home Builders in Washington.

Because it's not clear if inflation is here to stay, some economists don't think the Fed will actually hike rates. Instead, it may simply opt to warn that it has a "bias" towards raising rates in the future if signs of inflation persist.

In the past, the Fed has in fact reported it was leaning toward raising rates and then did nothing. This happened last spring. It continued that bias until August when the Fed said it was reverting to a "neutral" position. Then, in September it cut interest rates.

"It's kind of like a tornado warning: It puts everyone on notice that a policy change is imminent and you better take cover," says Paul Kasriel, an economist at Northern Trust Company in Chicago.

That's what started to happen in the financial markets on Friday. Almost as soon as the inflation news came out, the stock market started sliding. As yields increased in the bond market, the stock market's slide accelerated.

By the end of the session, the bond market had anticipated a 0.25 percentage point rise in short-term interest rates. Mr. Kasriel expects the selling pressure in the stock market could continue as people catch up with the inflation numbers.

In the past, such slides have offered investors a buying opportunity. This could be the case again. "Stocks will probably go sideways for the balance of the year, but if your horizon is longer than a year, yes, it's a good idea to buy on dips like this," says Kathleen Camilli, director of economic research at Tucker Anthony in New York.

Let's all watch the Fed

Over the short term, investors are likely to remain cautious until the Federal Reserve meeting is over. "I think investors will look to see if this is inflation noise or a sea change," says Sam Stovall, a senior market strategist at Standard & Poor's.

Ms. Camilli thinks the past week will be considered a turning point. Secretary of the Treasury Robert Rubin, who guided the country during its times of prosperity, has resigned. There are signs that global growth is starting to revive. And interest rates have suddenly shot up.

"This week may have been very important," says Camilli.